Many real estate investors are familiar with the 1031 exchange and how it can be used to defer capital gains taxes on the sale of investment property when reinvesting in “like-kind” replacement property.
The like-kind definition under IRC Section 1031 is relatively broad, stating that properties must be held for business or investment purposes but do not need to be of the same grade or quality. For example, an apartment complex can be exchanged for farmland or an office building for a self-storage facility.
But investors may not be aware that certain oil & gas assets also meet like-kind requirements. As a result, they may be a compelling option for many looking to diversify their investment portfolios further.
Why Oil & Gas?
From the moment Edwin Drake completed what is believed to be the first drilled oil well near Titusville, Pennsylvania, on August 27, 1859, interest in oil and gas investing has been an essential component of the American economy.
Today, while U.S. production has slowed with lawmakers focusing on transitioning our energy usage to renewable sources like wind and solar, we remain a prolific producer. Only a few years ago, the U.S. was the world’s largest oil producer. And as reported by Deloitte in its 2022 Oil & Gas Industry Outlook, “the oil and gas industry has rebounded strongly throughout 2021, with oil prices reaching their highest levels in six years.”
So, for investors wondering about the strength of the fossil fuel industry in the now and into the future, oil & gas production meets 57% of the world’s energy consumption needs. Producers large and small continue their drilling programs, and that means potential ongoing opportunities for investors.
What Qualifies for a 1031 Exchange?
While not all oil and gas investments meet 1031 exchange like-kind requirements, a few types of investments do.
A working interest in oil and gas means an investor’s ownership in a mineral lease and producing well. The tax code deems the lease and well as “real property,” enabling investment property owners to exchange a rental property, retail space, or farmland for a participating interest in oil and gas property. With a working interest, the investor is due a percentage of profits generated from the production but is also responsible for his share of the operating costs.
Mineral Royalty Interest
An investor who owns a mineral royalty interest in an oil and gas investment can receive a designated percentage of the potential profits generated from production. However, unlike a working interest, a mineral interest owner is not responsible for any costs associated with production. Mineral royalty interests are also considered real property under the tax code.
Delaware Statutory Trust (DST)
A popular option for 1031 exchangers interested in oil and gas ownership is the DST. A DST is an investment structure that meets 1031 exchange like-kind property requirements and enables investors to own fractional interests in a portfolio of properties. In the case of an oil and gas DST, the underlying “properties'' are often a pool of mineral royalty interests.
Oil and gas DSTs often appeal to investors because the DST sponsor has already accomplished the due diligence process of identifying, evaluating, and selecting the properties in the trust. Conversely, investors looking to own working interests or mineral royalty interests need to conduct their own due diligence, which can often be tedious and confusing.
We hope this discussion has helped you understand this lesser-known replacement property option available to 1031 exchangers. As with any investment, you should be familiar with any risk factors, and oil and gas investments may be riskier than types. That is why It is essential to work with an experienced advisor who can help you properly evaluate if an oil and gas 1031 exchange is appropriate for you.
If you want to learn more about oil and gas investing, you can download our newest guide Investing in Oil & Gas: What You Need to Know here, or simply contact us directly at 916.965.1879.
This is for informational purposes only and does not constitute as individual investment advice. Bangerter Financial does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results.
Potential cash flow, returns and appreciation are not guaranteed. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney.
Investment advisory services offered through Bangerter Financial Services, Inc. A state Registered Investment Advisor. Registered Representative and securities offered through Concorde Investment Services, Inc. (CIS), member FINRA/SIPC. Bangerter Financial Services, Inc. is independent of CIS.
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